The Efficient Market Hypothesis

Chapter 8

Learning Objectives

Understand the concept of market efficiency

Understand the investment implications of the various levels of market efficiency

Develop a thorough understanding of the tests of market efficiency and observed market anomalies

Market Efficiency A market is efficient when it uses all available

information is quickly incorporated into prices.

Efficiency is the degree to which prices reflect

available information.

If prices reflect all available information then

what causes prices to move?

New Information When information is released it contains two

components Anticipated: Information already included in the price Unexpected: New information that is not currently priced

The market prices assets based on what is expected to happen (Anticipated Information)

Unexpected information causes the market to change its expectations → Moving prices Result: Prices change until expected returns are exactly

commensurate with risk.

4

11-5

Stock Price Reaction to CNBC Reports

A Random Walk Unexpected information arrives RANDOMLY Therefore price changes will be random

Price tomorrow = today’s price + random (+/-) If price changes are random does that mean they

are uncaused?

6

7

Price: This Week & Next

Do you see a pattern?

Why are price changes random?

Prices react to information Flow of information is random Results in random price changes

How prices move

Stock prices are the consequence of intelligent investors competing to discover relevant information These discoveries occur randomly

We expected returns to generally be positive over time

These two trends results in stock prices having:

→Positive trend with random movements around trend

Information The MOST precious commodity on Wall Street

Strong competition assures prices reflect information.

The first to learn something new will make moneyThe marginal return on research activity may be so

small that only managers of the largest portfolios will find them worth pursuing.

Only ones with enough capital to make it worth while Can use leverage to juice returns

The Value of Information: Real Ex Pacific Century Cyberworks

Was going to be added to Hong Kong Index, in a major way

Since Index would be buying up shares, price would rise, so everyone started buying shares

One investor in Japan went to Hong Kong to get as much information about the deal as possible

Discovered the share weren’t being bought on the market Shares would come from the founder, increasing the supply

What do the investors who bought need to do? What does our investor do?

Short and made millions in minutes

12

Potential Causes of Efficient Markets Investor Rationality

Everyone is rational → Everyone makes the right decision

Independent Deviation from RationalityNo one is rational → Everyone makes the wrong

decision but each makes a different wrong decision Average out the wrongness

ArbitrageOnly some people are rational → Smart money takes

from less smart money

13

Types of Efficient Markets

Weak

Semi-Strong

Strong

14

Weak Form Efficiency

Prices reflect all information contained in past prices and volumesNo investor is able to form a trading strategy based

on historic prices and volumes and earn an excess return

15

Disbelievers

Chartists, or Technical AnalystsAnalyze “charts” of a stock‘s Price and/or Volume

Chartist believe in identifiable and predictable patterns in these characteristicsMake investment decisions based on these patterns

Brokerage firms tend to love chartists

16

Head and Shoulders

Why Technical Analysis Fails

-If there is a profitable pattern, everyone would do it

-If everyone follows the same strategy competition will eliminate any opportunity associated with the pattern

Sto

ck P

rice

Time

Sell

Sell

Buy

Buy

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Semi-Strong Form Efficiency

Security prices reflect all publicly available information.Encompasses weak form efficiency

Publicly available information includes: Historical price and volume information

Published accounting statements

Information found in the WSJ

Disbelievers Fundamental Analysts

Use economic and accounting information to predict stock prices

Try to find firms that are better than everyone else’s estimate.

Try to find poorly run firms that are not as bad as the market thinks.

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Strong Form Efficiency Strong form efficiency says that anything

pertinent to the stock price and known to at least one investor is already incorporated in the security’s price.Public & PrivateImplies: Insider trading will not earn excess return

Strong form efficiency incorporates weak and semi-strong form efficiency.

Disbelievers

Pretty much everyone Insiders trading is generally profitable

Galleon Raj Rajaratnam

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EMH: Active v Passive Management Passive Management: Believes the market is efficient

→ Does NOT attempt to outsmart the marketBuy well-diversified portfolios without looking for

mispricing Index Funds and ETFs

Active Management: Believes the market is not perfectly efficient → Hunts for mispricingAn expensive strategySuitable only for very large portfolios

Are Markets Efficient: Will the Debate EndWall Street is predicated on the idea that the market is inefficient, Academics general need an efficient market Magnitude Issue

Only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort.

Selection Bias Issue Only unsuccessful investment schemes are made

public; good schemes remain private. Lucky Event Issue

11-26

Weak-Form Efficiency Tests

Look for patterns in stock returns Returns over the Short Horizon

Momentum: Good or bad recent performance continues over short to intermediate time horizons

Returns over Long HorizonsReversal Effect: Episodes of overshooting

followed by correction

1 2 3 4 5 6 7 8 9 100.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

1.80%

2.00%

Average Returns to Momentum Portfo-lios (1967-2010)

Momentum portfolio returns based on 6-month past returns

11-28

Small Firm Effect January Effect Book-to-Market Ratios Post-Earnings Announcement Price Drift

Semistrong Tests: Anomalies

Average Annual Return: 10 Size-Based Portfolios, 1926-2010

1 2 3 4 5 6 7 8 9 100

5

10

15

20

25

19.8

17.0 16.615.9

15.2 15.1 14.613.5

12.9

11.0

Size decile: 1 = small, 10 = large

An

nu

al

retu

rn (

%)

Average Annual Return as Function of Book-to-Market Ratio, 1926-2010

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

12

14

16

18

20

11.011.8 11.7 11.7

13.1 13.4 13.4

15.516.1

17.3

Book-to-market decile: 1 = low, 10 = high

An

nu

al r

etu

rn (

%)

11-31

Study the impact of a particular event on a firm’s stock price. EX: Earnings or Dividend announcements Test of the Semi-Strong EMH

Look at how quickly prices adjust to the announcement Looking for under, over, early, delayed reactions

Event Studies

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Event Studies: Dividend OmissionsCumulative Abnormal Returns for Companies Announcing

Dividend Omissions

0.146 0.108

-0.72

0.032-0.244-0.483

-3.619

-5.015-5.411-5.183

-4.898-4.563-4.747-4.685-4.49

-6

-5

-4

-3

-2

-1

0

1

-8 -6 -4 -2 0 2 4 6 8

Days relative to announcement of dividend omission

Cum

ulat

ive

abno

rmal

ret

urns

(%

)

Efficient market response to “bad news”

CARs Around Earnings Announcements

Interpreting the Anomalies

The most puzzling anomalies are price-earnings, small-firm, market-to-book, momentum, and long-term reversal. Fama and French argue that these effects can be explained

by risk premiums. Lakonishok, Shleifer, and Vishney argue that these effects

are evidence of inefficient markets.

Interpreting the Evidence

Anomalies or data mining?Some anomalies have disappeared (e.g.

size).Book-to-market, size, and momentum may

be real anomalies as they exist in many markets and asset classes around the world.

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Mutual Funds Performance If the market is semi-strong form efficient,

then mutual fund managers, should not be able to consistently beat the average market return

When we compare the record of mutual fund performance to a market index, we see that mutual funds are not able to CONSISTENTLY beat the market.Consistent with the market being semi-strong form

efficient

Figure 8.8 Persistence of Mutual Fund Performance

Figure 8.9 Risk-Adjusted Performance in Ranking Quarter, Following Quarter

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Mutual Fund Performance

Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).

-2.13%

-8.45%

-5.41%

-2.17% -2.29%

-1.06%-0.51%-0.39%

All funds Small-companygrowth

Other-aggressive

growth

Growth Income Growth andincome

Maximumcapital gains

Sector

So, Are Markets Efficient?

The performance of professional managers is broadly consistent with market efficiency.

Most managers do not do better than the passive strategy.

There are, however, some notable superstars:Peter Lynch, Warren Buffett, John Templeton,

George Soros

Efficient Markets & Portfolio Management Even if the market is efficient a role

exists for portfolio management:DiversificationAppropriate risk levelTax considerations

Efficient Markets & Resource Allocation If markets were inefficient, resources would be

systematically misallocated.Firm with overvalued securities can raise capital

too cheaply.Firm with undervalued securities may have to pass

up profitable opportunities because cost of capital is too high.

Efficient market ≠ perfect foresight market

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EMH Exercises Indicate whether or not the EMH is contradicted,

if so which form of EMH is contradicted An investor consistently earn an abnormal return over

that expected by the market by examining charts of historical prices

The acquisition of the latest annual report of a company enables an investor to earn an abnormal return.

A stock which has been fluctuating between $25 and $27 in the last three months suddenly rises to $40 per share right after management announces a new project that has a promising impact on the firm's expected future cash inflows.

By subscribing to the Value Line Investment Survey, an investor can earn at least 5% over that earned by the market on comparable risk investments.